Thomas Shelton Blog Post 4

Thomas Shelton

GVPT200

Mark Shirk

November 13, 2013

While the creation of CDOs brought on one of the worst economic crashes in American and world history was it a necessary evil? Before the economic crash many companies were willing to do anything regardless of the consequence in order to get a quick pay off. It was only a matter of time until this mindset solely based on profits would back fire. Many of these companies were unaware or choose to ignore the fact that CDOs were a ticking time bomb because, they decided to focus on short term profits. Even when one of the most prestigious investors of the modern world, Warren buffet, claimed that CDOs were, “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”(Buffet). Still companies refused to acknowledge the effect their actions would have on the entire world.

CDOs were created in order to let investors remove the loan from their books and place the risk on another company. The main reason that CDOs had become a trillion dollar market is because the returns on these sales were often greater than those of corporate bonds who shared an equal credit rating. By passing off the loans and all their risks, companies were able to free up more of their money which they could use to create even more loans and continue the cycle. Many foreign investors saw this a huge opportunity as well because they could acquire these collections of loans tax free from American companies. The trade of CDOs was a win win situation for both the buyer and the seller until the loans the CDO were built off of fail.  Companies saw this as a quick way to make massive profits but failed to realize the consequences of the CDOs failing along with the company that purchased the CDOs.

The consequence that these investors failed to realize was that their actions would cause the worst economic crash since the great depression. Because these investors chose to ignore Berkshire Hathaway CEO, Warren Buffet’s, and the IMF chief economist, Raghurman Rajan’s, complaints that CDOs would destroy the world economy these companies sealed their own and our fates. Even before the CDOs lost their credit and crashed, the housing market had skyrocketed because mortgage loans made up many of the CDOs. The increased housing prices combined with the fact that banks would give a loan to almost anyone who wanted one created a recipe for disaster for both the person who took out the loan and whomever purchased the CDO that the loan was included in. The inability for the customer to pay back the loan they could never afford in the first place and that the loan rates could not be re-negotiated forced hundreds of thousands into debt which in many cases turned into bankruptcy. Once the CDOs had lost all credibility many huge investment companies and banks suffered the same fate as their customers. Companies like Citigroup had suffered enormous losses because of the failure of CDOs, Citigroup’s market value alone had lost over $220 billion over the course of two years. The failure of these companies who were seen as to big to fail had to be bailed out by the government in order to further protect the U.S citizens. In addition to the FDIC covering 90% of Citigroup’s $312 billion dollar portfolio, Citigroup was also forced to cut their 350,000 person workforce by over 30%. Now this was only one company’s losses, there were hundreds of other companies who suffered the same fate many of which were not lucky enough to be bailed out.

Now after it is all over and the damages have been accessed what have the American government, citizens and companies learned? After many companies nearly as well as became bankrupt it forced every single company and investor that the long term consequences of their actions need come before profits. Many companies also learned that no matter how large they may be they can still fail if they are not lucky enough to be saved by a government bailout. This economic crisis made companies realize the affect they had on the world economy and their actions alone were enough to bring the entire thing crumbling down around them. The American people were forced to improve their knowledge of their finical situation as well as being able to manage their finances because hundreds of thousands of people lost everything they owned because they bought a home they could not afford. This crash also forced many citizens to create a backup plan if they lose their job so they would not end up like those who were cut from these investment companies. The American government also learned that they must keep a watchful eye on the trading and investments of multibillion dollar companies in order to avoid another economic crash because they can and will fail. Then when they do fail the U.S government must be capable of bailing them out if the American people cannot afford to have this company fail. While it is a very drastic and horrible way to learn these lessons how else would we learn and better prepare for it if it never happens? These companies would continue to only focus on their profits unless they suffered an enormous loss because of their actions. The American people would never be as finically knowledgeable and responsible as they are now because of the crash. Likewise the government learned that they have to regulate these markets as well as be prepared to bail out billion dollar losses. The economic crash of the 2000’s was only a matter of time and now we are more prepared than ever to prevent the next one.

Warren Buffet on Derivatives." Fintools.com. Berkshire Hathaway, 2002. Web. 13 Nov. 2013. <http://www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf>.